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Greek drama escalates

01 July 2015 Izak Odendaal, Old Mutual Wealth
Izak Odendaal, Investment Analyst at Old Mutual Wealth.

Izak Odendaal, Investment Analyst at Old Mutual Wealth.

The world has been holding its breath during the negotiations between Greece and the European Union to release the last tranche of bail-out money before the current bail-out plan expires at the end of this month. After promising signs of Greece and Europe clinching a deal, dramatic events followed. Creditors rejected what appeared to be a reasonable offer from the Greek government and made a counter-proposal of its own. In a dramatic move, the Greek government announced on Friday that they would call a referendum that will take place on 5 July.

This is an opportunity for Greek voters to decide whether staying in the eurozone is worth swallowing the bitter medicine. In the event of a ‘yes’ vote, we will likely see a change of government, while a ‘no’ vote makes exit the most likely outcome. It is unlikely that the European Central Bank (ECB) will continue providing emergency funding to Greek banks if there is no deal as it is one of Greece’s bondholders and Greek banks will not be able to operate using the euro. Capital controls were imposed over the weekend and banks and the Greek stock exchange are to remain closed this week. Strict limits have been placed on daily cash withdrawals and overseas transfers have been frozen. 

Either way, the Greek economy will suffer further damage. Understandably, financial markets have reacted negatively to the uncertainty, and are likely to be nervous until there is a clear outcome. However, this is not a second Lehman Brothers collapse. While the ECB might let Greece fail, it has made it clear that it will counter any financial contagion. It has the tools and the mandate to do so.

Greece unlikely to derail Eurozone recovery

Since the Greek drama has been dragging on for five years, most investors have had plenty of time to reduce their exposure to Greece. While there might be some financial fall-out, the risks were well known. It is worth noting, as mentioned by a recent Bloomberg article, that although China is growing at its slowest rate in two decades, it will add the equivalent of four Greek economies to its gross domestic product this year. Greece is tiny compared to the global economy. In the longer run, a Greek exit from the eurozone will raise important questions on the supposedly irrevocable nature of the currency union that will outweigh the economic or financial impact. The eurozone economy continues to improve. Eurozone composite purchasing managers’ index (PMI) jumped to a 49-month high level of 54.1 in June (a reading of above 50 suggests an expanding economy). The composite index reflects both manufacturing and services. The second quarter average also rose compared to the first quarter. The improved PMI was led by the two largest economies, Germany and France. According to survey compiler Markit, the latest reading is consistent with economic growth of around 2%, which would be the best performance in five years. 

America is still okay

The US manufacturing PMI slowed further in June, but remains at a fairly high level of 53.4. US manufacturers are still being hit by the strong dollar. On the positive side, employment continued to expand. Staying with the US, the first quarter slump was not quite as bad as previously thought. The economy contracted by 0.2% quarter-on-quarter, revised from the previous estimate of 0.7%. Consumer spending was in fact better than expected, which addresses one of the puzzles of the US economy, namely that despite low inflation and steady jobs growth, consumer spending was disappointing. Personal consumption data for the second quarter so far has also picked up. Still, for the 37th consecutive month, annual inflation undershot the Federal Reserve’s 2% target. 

China’s cooling economy and overheated stock market

The Chinese economy, however, continues to be plagued by overcapacity, slowing demand and weak inflation. The HSBC Chinese manufacturing PMI remains below 50 points, but has improved over the past three months, possibly a reflection that the central bank’s interest rate cuts have gained some traction. Meanwhile, the wild swings on the Shanghai Stock Exchange over the past few weeks confirm the view that speculative fever has gripped the markets. In response to last week’s declines, the Chinese central bank cut interest rates for the fourth time since November. Against this backdrop, index provider MSCI’s recent decision to not include Shanghai and Shenzhen listed shares (the so-called A shares) in its benchmark emerging markets index appears to have been  spot on. It would have caused billions of dollars tracking the index and flowing into these markets at the wrong time. Currently, only Chinese companies listed in Hong Kong are included. At the same time, the weighting of South African shares in the index (currently 7%) would have reduced, leading to an outflow of index-tracking funds. MSCI will revisit its decision next year. 

Chart 1: Chinese and emerging market equity indices

Source: Datastream

 

Current account deficit improves, but capital spending disappoints

The Reserve Bank’s Quarterly Bulletin showed that South Africa’s current account deficit narrowed to R189 billion or 4.8% of GDP in the first quarter of 2015 from 5.1% in the previous quarter (seasonally-adjusted and annualised). The current account is the broadest measure of South Africa’s trade relations with the rest of the world. If there is a deficit, it essentially means we spend more foreign currency than we earn on a continuous basis. This shortfall is met either from our stock of forex reserves (which is not large) or through investment flows or loans. These flows can either be direct or long-term investments, or portfolio flows. According to a report released by the United Nations last week, fixed investment flows were negative in 2014. Fixed investment abroad by South African companies rose to $9.8 dollars last year, while fixed investment flows into South Africa fell to $8.1 billion. South Africa is therefore reliant on portfolio inflows, the volatile nature of which keeps the SARB leadership up at night: if the flows reverse, the rand could fall out of bed. South Africa’s current account deficit is large by international standards. 

Trade deficit widened, but dividend inflows surged

The current account has two broad components. The first is the trade account, measuring imports and exports of goods. The deficit on the trade balance increased to R71 billion from R35 billion in the fourth quarter of 2014. Overall, export volume growth was 3.4% in the first quarter, but was completely overshadowed by the fall in commodity prices and value of exports went down by 2.3%. Import volumes grew by 3.6%, but the decline in the oil price meant the value of imports only grew by 1%. 

The other component of the current account measures net transfer, income and services payments. The latter includes services such as tourism and travel, and the insurance costs associated with trade. The income payments (dividends and interest) relate to the ownership of foreign assets by South African residents, and the ownership of local assets by foreigners. While cross-border ownership has increased in both directions, the SARB estimates that the ratio of dividend inflows to outflows increased to 40% since 2012, higher than most other emerging markets. This is due to increased ownership of foreign listed and unlisted entities by South African firms and investors. Dividend payments from abroad surged in the first quarter, helping close the deficit. Therefore the deficit on the services, income and transfer account narrowed significantly from R163 billion in the fourth quarter of 2014 to R117 billion in the first quarter of 2015 (from 4.2% to 3% of GDP). 

Fixed investment spending growth is slow

The Quarterly Bulletin also includes a breakdown on fixed investment spending. This is important because fixed investment or capital spending enables and enhances future economic activity. Case in point is the lack of capital spending in the electricity sector over the past fifteen years that is now haunting us. Real fixed investment spending by public corporations (Eskom, Sanral, Transnet etc.) barely grew over the previous four quarters, but remains at reasonably high levels. Real fixed investment spending by general government - schools, hospitals, vehicles – continues to grow at a fairly healthy clip of 7% year-on-year in the first quarter.  

Most fixed investment spending is done by the private sector, including buildings, machinery and vehicles. This is also the largest area of concern, as it contracted in 2014, and continued to be weak in the first quarter. Independent power producers was the only sector that showed notable growth over the past year, but this has slowed down as the projects linked to the first two rounds of the Department of Energy’s Renewable Energy Independent Power Producers Procurement Programme (REIPPPP) have been completed. 

How can South Africa improve?

The IMF concluded an assessment of the local economy last week and made some recommendations. Restoring a reliable electricity supply is a top priority, and it supports higher tariffs to enable this, but Eskom should cut costs and improve. There should also be greater private sector participation to increase capacity. Reforms are needed to reduce the regulatory burden on especially small businesses and increase competition. South Africa also desperately needs more skilled workers, and a short-term solution would be to allow easier immigration.

Chart 2: South Africa’s Current Account Balance

 

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